A trailing stop is when you use a set of rules to move your stop in the direction of the trade to reduce risk, eliminate risk or lock in profits. The idea is to start the trade with your stop at a certain level, and then move the stop as the trade progresses. In the end, price action decides when to get you out of the trade by hitting your traililng stop.
Before You Use A Trailing Stop Strategy
Trailing stops, if you choose to use them, are part of your trade management strategy. Therefore, I think it important to know about the other elements of your trade management strategy that you can use with trailing stops. Trade management is what happens after the trade is triggered and can be a combination of various actions.
Partial Close
You have to decide if you are going to close a portion of your trade at a certain level. This puts some money in your account and lets the rest run. For example, you could take off half the trade size at a set pip number, and then let the rest of the trade run to be closed using the trailing stop strategy you choose.
Targets
You have to decide if you are going to have a final target for your trade, or if you are going to let the trade run until it is stopped out by the trailing stop. If you have a final target, this is where the trade will be exited if price reaches this level. The trailing stop is used to reduce risk, eliminate risk and lock in profits along the way. If price reverses before your final target is hit, the trade will be stopped out at the trailing stop level. If you don’t use targets, the trade runs until stopped out by the trailing stop.
Break Even Stop
One of the most common trailing stops is the break-even stop. At some point during the trade, you remove the risk by moving the stop loss to the entry level, or a few pips beyond. At this point, you have no risk on the trade and if price reverses you don’t lose anything.
Combination Trade Management
Obviously, you can use one or multiple of these trade management tactics. Here is an example of using them all…
- You enter a trade with a 50 pip initial stop and a 200 take profit target.
- When price goes 50 pips in your favor, stop loss is moved up 25 pips, reducing risk.
- When price hits 75 pips, partial profits are taken and the stop is moved to break-even, putting money in your account and eliminating risk for the rest of the trade.
- When price hits 100 pips, the stop is moved up to 50 pips, locking in profit.
- When price hits 150 pips, the stop is moved up to 100 pips, locking in more profit.
- Price reverses and takes the second part of the trade out at 100 pips.
Why Use Trailing Stops
When your first place a trade, you have to accept the initial risk of the trade. If for some reason price immediately reverses and takes out your stop, you need to be prepared to accept the full loss. But once the trade progresses in your favor, you can reduce risk, eliminate risk and lock in profits.
No trader likes to see a trade go in their favor and then reverse to take them out with a full loss. Using a trailing stop can keep this from happening. Instead of suffering when the price reverses, you can lose less, lose nothing at all or get our of the market with some profits in your account. In some instances, by letting price action dictate when to get out of the trade, you can take advantage of big, strong moves and maximize profits.
Why Not To Use Trailing Stops
When you enter the market, you should have clear rules for where you want to place your stop loss and take profit levels. This allows you to calculate your risk to reward ratio and use proper money management. From these calculations, you can calculate your profitability with different win / loss percentages. (For example, if I win 6 our or 10 trades, how much money I could make)?
When you use trailing stops, there is a good chance they are going to be hit because of the randomness of the market and the tendency to retrace. Many times price can go in your favor enough to trigger the trailing stop, reverse to take the stop out and then continue in the original direction. This makes it very hard to figure out your risk to reward ratio and potential profitability.
The Trading Psychology Of Trailing Stops
Trader’s psychology has a lot to do with if you use trailing stops or not. Trader’s psychology plays a major role AFTER the trade is placed and real money is at risk. This is the realm of trailing stops.
If you use a trailing stop, it is either going to turn out to be a good decision or a bad decision on a trade by trade basis. You cannot tell this before the trade, but only afterwards.
- If you used a trailing stop and it helped you make money on the trade you would have otherwise lost, it was a good decision.
- If you used a trailing stop and it kept you from making money you would have otherwise made, it was a bad decision.
If you are the type of person that cannot stand to see a trade go in your direction and then turn around for a loss, using a trailing stop is for you. These type of traders are happy to get out of the market without a full loss or with some money to show for the trade. The trailing stop is perfect for this.
If you are the type of person that cannot stand to see a trade get stopped out that would have hit the final target, don’t use trailing stops. These types of traders would rather suffer through losing trades than give up winners. The use of the trailing stop will result in trades being stopped out before final target, and therefore should not be used.
OK, this post got long. In the next posts, I’m going to assume you want to use trailing stops and go over specific trailing stop strategies in detail. If you have experience using trailing stops, or a favorite trailing stop strategy please share by leaving a comment.
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